Monday, July 26, 2010

NPVs, discounted cash flows, things like that

Wonk out! Here's an excerpt from IKN64 out yesterday that sampled the fun and laughter world of mine project economics. Posted up here on the blog by request from a subscriber (who'd like to show his non-subbing friend the piece). No probs 'GS', enjoy.

Talking discounted post-tax cash flows

In ‘Market Watching’ below, as well as in the two reports prepared by other analysts attached with today’s issue, we take a look at the new PEA published by Antares Minerals (ANM.v) last week (1). But before getting there I’d like to focus on one element of the PEA news release as it gives us some insight into the way junior miners often present their case as an investment vehicle in the rosiest manner possible; in fact it’s one that I believe to be irresponsible to the point of plain deception. We’re going to use ANM’s news release to highlight this because (and be very clear on this), ANM is one of the good guys, it’s doing the right thing by the market and investors and not trying to deceive anyone. This is probably due to a combination of the good, honest, straight-shooting people that run the company coupled with the fact that the Haquira deposit is so darned good it doesn’t need any extra dressing to prove itself to numbers people. It points back to the basic reasons why we recommend the stock as a ‘Top Pick’, too.

Here below are two tables pasted from the NR that show the Cash Flow models for Haquira. Before diving in we need to keep in mind that a PEA is not a definitive study and any of the current metrics being used by ANM might change by the time production day one comes around, but for the purposes of modelling we have to start somewhere so the things used by ANM (20 year mine life, 100k tpd flotation throughput, 30ktpd SX-EW throughput, 2:1 strip, 89c cash costs over first ten year etc etc etc on a hundred other variables) are taken as our fair baseline.

I’ve highlighted a couple of the numbers and titles in red to help with the explanation which you can refer to at your leisure (I won’t be discussing them all here). But the main one to bear in mind is the $1,069m cash flow number in the first table. This is the one presented by ANM in its news release headline that gives us the 16.4% Internal Rate of Return (IRR), the one that assumes a base case for the metal ($2.25/lb Cu) and also an 8% discount to the Net Project Value (NPV) of Haquira.

(i)Three year historical trailing average for LME price of copper= US$2.95/lb Cu

Before continuing, let’s talk about why the “discount to NPV” (those lines like “NPV 8%, for example) exists. A way of presenting this is to imagine Person X investing a sum, let’s say one million dollars, in an investment that promises him or her $1.5m in a few year’s time (let’s say five years). Now that might look at first sight as if X will make a 50% profit, but if s/he hadn’t sunk $1m into the project it could have been used for something less risky but still lucrative. The typical counter-example is to imagine that $1m being put into government bonds or a time deposit that pays (again let’s say) a safe and steady 4% annual interest compounded. At the end of those five years, the $1m would become $1.217m once interest had been added and compounded. So the $500,000 nominal profit is really $283,000, which is a lot less.

The difference in those two results is a “risk premium”. If person X wants to put $1m into a relatively safe place, then $217,000 profit is the result. But choose a riskier invetsment and the return is higher ($500,000). It’s then up to the person to decide whether the extra reward is worth the extra risk (the same way as we equities investors make risk/reward decisions, often on a more intuitive level).

There is a second idea related to the NPV discount, which is related to the first but needs a note. The so-called “time value of money” theory notes that people prefer to have cash in hand than locked up over a period in time in any investment (be they safe ones like bonds or risker ones like mining). Therefore the potential investor needs to be compensated for their waiting by a monetary profit. There’s no need to go into the mathematics (it’s a bit technical but nothing on Einstein levels), just to understand that the theory takes into account that future profits aren’t just desirable, but actively demanded by the investor. It’s capitalism, folks.

So once those two concepts are taken into account, it makes much more sense for a company such as Antares to present its project economics using a discounted NPV. In mining circles, there’s a convention to use an 8% NPV which most players most of the time consider a fair benchmark (again, let’s speak very very roughly and say “5% for the time deposit interest, 3% as simple reward for waiting” to get a handle on things).

Now to the point I wanted to make about the ANM news release and project economics: ANM could have chosen a sexier copper price to present its economics. It could have chosen a lower discount rate. Also, it could have used a typical trick used by other miners and presented its economics on a pre-tax basis (just check the differences in those charts, especially when the NPV discount is higher). But it didn’t. It chose to pitch its headline using a low copper price, a industry-understood 8% discount and all on a post-tax, post-royalty, post-worker profit sharing participation (that’s 8% in Peru) basis. Also, on talking to CEO John Black yesterday I was told that the PEA added a 20% contingency price to every single line item, which is somewhat unusual in mining circles as a typical (and accepted) approach would be to add 20% contingency to some things but nail specific prices on other things that the company believes can be priced pretty accurately, even at this early stage.

All these conservative parameters and the IRR still comes out at 16.4%, the project shows robust economics and Haquira clearly “works” as a mine. So thanks to this modest, conservative approach used by ANM we can take this PEA as a solid and true baseline and assume that anything that affects project economics will affect it to the upside...it’s all blue sky from here, folks.

Now we have that out there, check how this news release (2) published by South American Silver (SAC.to) presented the PEA for its ‘Mallku Khota’ silver/indium project to the world in 2009. Here’s the first paragraph:

February 25, 2009

South American Silver Corp. (“SASC” or the “Company”) announces the results of a NI 43-101 compliant Preliminary Economic Assessment Study (“PEA”) on its 100% owned Malku Khota silver – indium - gold project located in central Bolivia. The study includes a Base Case with a pre-tax undiscounted NPV of US$1,233 Million (0% discount rate) and IRR 50.7%.

It also goes with using the “three year trailing prices” for silver and indium, its key project byproduct. Hopefully you can see the problem here but if not, reflect that if ANM.v had used to same cherrypicked criteria as SAC.to in its news release, it could have run with a project cash flow of $11.486Bn in its headline instead of the $1.069Bn it preferred. TEN TIMES HIGHER!

Yes SAC.to is one of my bugbear stocks on the blog, but it’s not chosen as an object of derision just because I don’t like the company logo. Aside from all the issues it has with its main country of operation (Bolivia) it tries to present project economics in a way that’s so misleading it should be outright banned by the financial authorities. SAC isn’t the only company out there that does this kind of financial manipulation...not by a long chalk. But it’s a good example and one that you can use as your counterpoint when checking out PEAs PFSs and FFS in the future. When it comes to mine economics, the devil is in the details.